Elsevier

Journal of Corporate Finance

Volume 23, December 2013, Pages 88-107
Journal of Corporate Finance

Equal opportunity rule vs. market rule in transfer of control: How can private benefits help to provide an answer?

https://doi.org/10.1016/j.jcorpfin.2013.07.007Get rights and content

Highlights

  • The equal treatment rule (EOR) introduces a quasi-process of negotiation.

  • EOR modifies the terms in a transfer of control compared with the pure market rule.

  • EOR may facilitate transfer of control in a framework of concentrated ownership.

  • It strengthens discipline but quality of information may deteriorate.

  • We explain why some outside investors may not use the exit option in EOR.

Abstract

Having been introduced in the European Union and in many other countries, the equal opportunity rule is seen as protecting investors in the event of a transfer of control. This rule should be analyzed in a context of appropriation of private benefits between the new controlling shareholders and the outside investors. Both parties need to design a new implicit contract to share the firm's ownership. Using a signaling model, we show that the new controlling shareholder issues signals to outside shareholders to deliver private information on a firm's future economic return and her private rate of appropriation. The ownership stake of the controlling shareholder and the premium embedded in the acquisition price are key parameters. In a controlling ownership system, the equal opportunity rule modifies the relative behavior of controlling and outside shareholders. The quality of information deteriorates but the discipline on appropriation may become stronger.

Introduction

Transfers of control aim at disciplining a firm's management and improving its performance. They are a key mechanism in the optimal use of capital and, from a welfare point of view, the regulation of transfer of control is of upmost importance. A recent paper by Enriques et al. (2013) contests this idea and states that the regulation design of transfer of control should be set at firm levels and that designing regulation at a country level is not optimal. Firms are better positioned to decide which rule in a menu of rules is better suited to develop a specific category of contract named transfer of control. They state that takeover regulations should neither hamper nor promote takeovers, but instead allow individual companies to decide the contestability of their control. This idea is new and reopens the controversy of the optimal regulation of takeovers.

The traditional controversy opposes two legal regimes for transfer of control. The first one is the Market Rule, which is opposed to the Equal Opportunity Rule Bebchuk (1994). The Market Rule (also known as the “Street” rule) confers maximum freedom on a company's incumbent controller by enabling sale shares (hence control over the target company) to any acquirer offering an acceptable price. This applies to most private sale-of-control transactions in the USA. The Equal Opportunity Rule (EOR, also termed Mandatory Bid Rule) has its origins in the UK and now applies throughout the EU and in many other countries. Under a mandatory bid, an acquirer of a controlling stake in a listed company has to offer the remaining shareholders a buy‐out of their minority stakes at a price equal to the payment received by the incumbent controller. A definition of a controlling stake is needed to trigger the EOR. Most countries chose to apply a threshold of 30% of the voting rights.

This theoretical controversy seemed to have been overlooked for a long period as the institutional environment is settled by government regulations. However, this is not because institutional regulations have been enforced here or there that the question has no more interest. Historical considerations, ideology and pressures by group may explain why the Market Rule (MR) prevails in the US law. It is nevertheless with some exceptions: the states of Maine and Pennsylvania have Mandatory Bid Rules (Grant et al., 2009). The choices between MR and EOR are not permanent and irrevocable, as the European Union illustrated in 2005. The EOR was then enforced at the EU level and many European countries abandoned the Market Rule system. A geographical comparison shows that the EOR principle is now dominant in many countries in the world as in Australia, Hong Kong, Russia, Singapore, South Africa, Switzerland, Japan and, to some extent, in Canada (at least if the bidder pays a premium in excess of 15% over the market price).

The theoretical analysis has not definitely ruled over the optimal regime to develop transfer of control. Historically a large strand of the literature is in favor of the Market Rule (Bebchuk, 1994). The controversy between EOR and MR experiences a revival driven mostly by legal analysis and empirical studies. In recent contributions, Papadopoulos, 2007, Papadopoulos, 2013, Sepe (2010) and Enriques (2012) argue against EOR, emphasizing its cost and deficiencies, mainly in the EU context. Their analysis is mostly grounded on legal arguments and they remark that EOR did not lead to the integration of the market of transfer of control in Europe. On the pros side, McCahery and Vermeulen (2010) support the existing EOR rules in the EU. Schuster, 2010, Schuster, 2013 mentions that the costs associated with mandatory bids are not so high in comparison to its advantages. Enriques et al. (2013) propose that EOR should be recognized as a part of an “unbiased” takeover law to set up. Carvalhal da Silva and Subrahmanvam (2007) empirically analyzed the presence and removal of mandatory bid rule in Brazil where opt out possibilities exist at the firm level. They identify an influence of the rule on the premium size.

This question develops in a framework where private benefits exist as synergies are expected in a takeover. The capture or the sharing of these private benefits is the basic problem that exists irrespective of the level of protection awarded by the legal system to investors. The ability to extract private benefits is not only a function of the legal system. Shareholding concentration is identified in most countries, even in common law countries such as the USA (Holderness, 2009). Dyck and Zingales (2004) demonstrated the worldwide existence of private benefits, even in developed capital markets and protective legal environment. They show that private benefits amount to 2.7% of the equity capital of US firms. Albuquerque and Schroth (2010) estimate that private benefits represent 3–4% of the target firm's equity of a sample of US acquisitions. Unfortunately these two studies do not address the question of the possible effect of the EOR rule.

Taking into account the existence and the importance of private benefits is crucial in transfers of control. In the same legal environment, the pyramidal structure of firms may explain different terms in acquisitions. Atanasov et al. (2010) considered a US sample of acquisitions of a subsidiary by a parent company. The authors show that subsidiaries bought by parents owning a minority stake are valued at a median 23% discount compared to peers. When considering majority-owned subsidiaries, they see no abnormal performance or valuation with peers. Even in a Market Rule system, appropriation exists and seems to be linked with the stake of controlling ownership. The issue of blockholder opportunism in the United States is however questioned by analyses showing that non-U.S. firms will choose to cross-list on U.S. stock exchange to bolster investor protection (Doidge et al., 2004).

Private benefits are by-products of this situation of control and appear either in the form of a pre-existing rent of control (Bebchuk, 1989), or of expected synergies by the acquirer. Even if private benefits are lower in countries where the investor's protection is good, they still exist particularly in private firms (La Porta et al., 1998). In that vein, a macro comparison of country corporate governance rules is often used to explain the difference in cross-border acquisitions (for instance, Bris and Cabolis, 2008, Kim and Lu, 2013). Nevertheless, at a macro country level the degree of investor protection cannot be seen as totally exogenous (Pagano and Volpin, 2005).

Even within the USA, differences exist between the states laws and the levels of antitakeover protection. Boone and Mulherin (2007) identify nine states among 50 where the antitakeover environment is strong. Surprisingly it seems that antitakeover states will make target firms more prone to choose negotiation. Indirectly it has some wealth effect where a negotiated process creates less value than a multi-bidders auction. These results are not crossed with the possibility of private benefits. The issue of the effect of takeover regulation on the process conditioning the transfer of control is still pending even in a single country framework.

However, the analysis of the takeover decision should be set at the firm's level. Private benefits are micro decisions which are set conditionally with regard to the legal constraints. For instance, these legal rules can be sketched using the probability of being sued and convicted, a monetary sanction and the cost of a takeover. At et al. (2004) show that in such a legal framework the controlling bidder can be driven to optimally acquire more than 50% of the shares. If they take into account the fine, they ignore the legal constraint introduced by the MR or the EOR on the takeover terms.

How does the transfer of control develop in a situation where private benefits exists? The question is not only geographical and/or empirical with a comparison of M&A activity between countries where different rules apply. Which rule, EOR or MR, helps or hurts the transfer of control the least, is a too simple question. The optimality of the regulation is often addressed in a scheme where the rule is exogenous so behaviors will integrate the constraints and costs imposed by the rules. We have to consider the existence of a situation of control of the firm by an incumbent controlling shareholder who is willing to sell it to an acquirer. The private benefits are not mechanically conditioned by the legal environment, so we will follow the idea that the anticipated future private benefits are endogenously determined in the takeover process.

Within an equal opportunity rule framework, when the takeover is initiated the outside shareholders have to choose between keeping their shares and selling them at an acquisition price that is always above the market price. Why, in an apparently irrational way, do outside shareholders, who benefit from a guaranteed price, not systematically sell their shares? Although tax reasons may explain it, many investors will refuse to accept an open unconditional bid. This puzzling question has not been extensively analyzed in the literature.

The basic question raised by the EOR is how the two preoccupations, optimality of transfer of control and cost/advantage of investors' protection, combine. Whatever the procedure or the form of transfer (public tender offer or private block trade), a new controlling shareholder substitutes for an old one. Albuquerque and Schroth (2010) show that in the USA the private benefits represent a similar part of the equity for the selling controller and the buying controller. As for the third party, outside investors face a new economic story and the firm in which they had previously invested becomes another economic project. Empirical analyses have mainly focused on ex post realized transactions. What is relevant is to analyze the influence of regulation ex ante on those transfers of control that were not ex post realized. Losses in optimality can be identified and can be put into balance with the actual protection of outside investors and the future profit they would have made under a simple Market Rule. The complexity of reassessing the history under different institutional environment explains the paucity of empirical results in the literature. Behavioral and experimental studies may be a promising field, yet not explored. Therefore, we need to compare how the setting of the terms of a transfer of control is influenced by the existence or an EOR. Boone and Mulherin (2007) insist on the importance of the prior private phase in the takeover process. They show that negotiation develops and that competition is stronger during this first phase than in the ensuing public phase of the bid. Considering a sample of 400 US takeovers, one-half of the target firms are auctioned by multiple bidders in the takeover process and the other half negotiates with only a single bidder. The choice between both channels is not harmful to the target's shareholders. The ex-post wealth effects are comparable. As consequence there is a need to focus on the private phase in the takeover process. This negotiation step is of course dominant in block transactions. We analyze the issue of EOR in the framework of a quasi-contractual process. We contribute to the literature, as Boone and Mulherin (2007) do not refer explicitly to the mandatory bid provision.

The relevant method is to use a contractual model as the valuation of the firm develops in a joint economic valuation framework between the new ruling shareholders and the outside investors. The problem is made complex in EOR because outside investors are not passive and will act to optimize the percentage of shares they sell back to the initiator at the acquisition price. We analyze this as an implicit contract mixing agency problems of future private benefits and signaling problems of delivering private information. Equilibrium is established through the two key parameters of an offer: the size of the block of control and the acquisition price.

In the paper, we show that, in an EOR context, both parties design the characteristics of an implicit contract in order to share the firm's ownership. Through a signaling process, outside investors will integrate an expected level of future private benefits into their valuation schedule. We show that the new controlling shareholder delivers private information to the outside shareholders on two key variables: the firm's future economic return and the rate of private appropriation. As in the Leland and Pyle's (1977) framework, ownership is a good signal: the higher the share of capital held by the controlling shareholder, the better the prospects of future economic return as perceived by outsiders. Another signaling effect results from the premium embedded in the acquisition price: the future profitability of the target under the buyer's ownership is increasing in the acquisition price. The buyer's private appropriation of future benefits also appears to the investors to be decreasing in the share the buyer acquires. In an EOR context, we highlight that the buyer takes into account the inferences the outside shareholders draw from his choices. The setting of EOR rule enforces a constraint because the buyer is no longer completely free to set the share of the capital he wants to purchase: the investors can force that share up by tendering their stocks to the buyer.

A major result is that the final stake that an acquirer obtains in a takeover subject to the EOR is endogenous to the minority shareholders' choice of how many of their shares to sell. How many shares minority shareholders sell, however, depends on the offer the acquirer makes and on the information that the shareholders infer from this offer. Through this channel, the EOR affects the acquirer's optimal offer. The equilibrium offer (and the minority shareholders' response) under the EOR is then compared to the equilibrium obtained in the absence of an EOR. Compared to the existing literature we demonstrate that under EOR outside investors influence the transfer of private benefits accompanying a transfer of control.

The setting of an EOR rule induces two specific consequences. Firstly, it initiates a self-limitation mechanism in future expropriation. Since the rate of expropriation is decreasing in the share the buyer acquires, he is encouraged to take a larger stake. The EOR exaggerates this process by giving the investors an exit option at the purchase price. The buyer can be forced to increase his stake involuntarily. The buyer's best response, since he does not want to buy the entire firm, is to reduce his rate of benefits appropriation. Secondly, in an EOR context, the bid price and the purchased share of the target company as signals are lower quality signals and convey less information to the market: the buyer's ability to signal is reduced by the exogenous constraint induced by the EOR. Moreover, we also explain why the exit option is only partially used by rational outside investors in an EOR system.

The empirical implications of our findings can follow four directions. Methodologically, the terms of the takeover will differ according to the capital concentration and the importance of private benefits. We show that the relevant analysis should focus jointly on the two key variables setting the transfer of control: the size of the controlling block and the acquisition premium. An empirical analysis has been proposed by Albuquerque and Schroth (2010) in a Market Rule context. A similar study could be done in an EOR environment. Secondly, the EOR may explain why some announced takeover failed due to the non-convergence of the contract process. The probability to agree to transfer control ceteris paribus is influenced by the EOR. An empirical test on envisaged but non-realized takeovers may be developed. Moreover, the importance of information delivery in the process of control is emphasized as it may help the agreement. The reduction of asymmetry of information should empirically be different in EOR or MR settings. This leads to a testable hypothesis. Lastly, a test comparing ex ante and ex post private benefits can be designed to check if the EOR has a disciplinary effect or not on private appropriation.

The remainder of the paper is divided into five parts. A review of the literature is presented in the second section. Section 3 presents the framework of a model referring to information asymmetries, future private benefits and expected economic return. 4 Contracting without EOR, 5 Contracting with EOR develop the model respectively without and within an EOR context. Conclusions are drawn in the final section.

Section snippets

Literature

The possibility and conditions of transfers of control have been extensively analyzed in the academic literature. In a well-known paper, Grossman and Hart (1980) showed that tender offers should be rare because a perfectly informed seller will ask for a price at least equivalent to the future value of the firm under a new management. The only possibility of stimulating buyers is the appropriation of a rent leading to the offer of a lower public offer price. Hirshleifer and Titman (1988)

Setting a contracting model

Similarly, to Albuquerque and Schroth (2010), we stand in the private phase of the acquisition process. We consider that the incumbent controller has agreed to sell its stake of capital. We analyze the equal opportunity rule for outside shareholders in a non-hostile takeover context. During the remaining time of the offer, outside shareholders make their choices by considering that the tender offer has been a success. Similarly, they know that a new controller has bought the controlling block.

Contracting without EOR

In a system without the equal opportunity rule, we maximize the controlling shareholder's net wealth. The existence of economic uncertainty enhances the investor's risk aversion. We introduce a utility function of wealth U(.) and consider the expected utility of wealth. Using Eq. (5) the net wealth of the new controlling shareholder is with re(.) and tA(.) set at their optimum:W˜A=αVe.re.+x˜tA.k+Ve.tA.kα.A

In order to optimize, we set the first derivative to zero with respect to the two

Contracting with EOR

We refer now to a situation with an equal opportunity rule. The wealth function of the acquirer should include a new variable αg, which is the part of the capital bought by the acquirer as a result of the mandatory bid rule.W˜A=α+α˜gVere.+x˜tA.k+VetAkα+α˜gA

The new controlling shareholder will optimize the number of shares bought by outside investors through the mandatory bid procedure or the price guarantee mechanism set into force during the takeover. However, he has to take into account the

Conclusion

The existence of the equal opportunity rule appears as far more important in a context of concentrated stock ownership and private benefits of control than in a framework of dispersed ownership. In a transfer of control, the possibility of a change in appropriation of the cash flow by the new controlling investor exists and is a source of risk for minor investors. The acquirer can use the bid acquisition price and his target ownership stake as signals to condition the takeover process.

This

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      This may curb the incentive to launch a takeover bid and reduce the frequency of value-enhancing takeovers (Burkart, 1995), although Betton et al. (2009) argue that a zero initial stake may be optimal in most bids to avoid the costs of rejection by the target's management. Despite its positive effects for minority shareholders, the mandatory bid rule may reduce the efficiency of the market for corporate control, such as by hampering bidders' ability to freely purchase shares because investors can tender their shares to bidders at the increased share price (De La Bruslerie, 2013). It may increase the costs of takeovers and act as an anti-takeover device (Enriques, 2004) because it prevents bidders from using coercive bid structures, such as partial bids and two-tier bids.

    I thank discussants at the 7th annual CIG Conference in Bordeaux, the 2009 Brest AFFI Conference, the 2009 Milano EFMA meeting and the 2010 Wiesbaden GLEA meeting. P. Six should be particularly mentioned for his help in a first version of the paper. The financial support of the Fédération Bancaire Française Chair in Corporate Finance is greatly acknowledged.

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